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Introduction

The international environment has not improved over the past few months. Financial
markets had stabilised around the region late in January, and by the time of
the Bank's Semi-Annual Statement on Monetary Policy in early May, exchange rates and share prices in most of the east Asian economies
had recovered a good deal of ground. By June, however, this had given way to
another period of pronounced instability, during which most currencies in the
east Asian region came under renewed downward pressure, and confidence about
economic prospects in the region waned further.

The main origin of the financial market movements in mid year was a reassessment
of Japan. The Japanese economy had effectively been in recession since the
middle of 1997, with the effects of tax increases being amplified by the loss
of export sales in Asia, and the corrosive effect of a banking system which
had made little progress over several years in overcoming high levels of bad
debts. The contraction intensified during the first half of 1998 and, notwithstanding
the forthcoming substantial fiscal package, confidence in Japan sank to a very
low ebb. In this environment, the yen weakened abruptly and, because Japan
is such a large economy in the region, this quickly added to uncertainty about
the prospects for recovery in Asia more generally.

Australian financial markets, and the Australian economy more generally, were inevitably
affected by the events in Asia. The Australian dollar has fallen substantially
against the US dollar and the European currencies over the past year, as markets
have factored in the effect of the regional turmoil on Australia's export
prospects. For much of this period, the Australian dollar has tracked the yen
quite closely, despite the very different paths of the Australian and Japanese
economies. Australian exports to the east Asian region fell sharply during
the December and March quarters – which was the period of most rapid
adjustment in the trade accounts of the Asian countries – but this decline has abated during the June quarter. There has also been some good news
in that a number of exporters have been quite successful in finding alternative
markets for their products. This has been clearest for resources, where export
growth has not slowed at all over the past year. In other cases trade diversion
is more difficult. Nonetheless, the decline in the exchange rate can be expected
to assist exporters in securing increased market share in US and European markets
over the coming year, and there should also be some benefits for those domestic
producers competing with imports in the Australian market.

Even with this increased flexibility, the international environment remains a very
difficult one. Forecasts of world growth have generally been marked down over
recent months because of the more widespread recessions in Asia and Japan,
and an expected slowing in growth in the US, although the outlook in Europe
seems to be improving all the time. Commodity prices remain under downward
pressure.

In Australia, it is clear that business conditions in parts of the manufacturing
sector are very difficult; this is only to be expected given the decline in
manufactured exports to the most crisis-prone Asian countries of around 50 per cent over the past year. The tourism industry
will also have been badly affected by the decline in Asian tourism, which has
only been partly offset thus far by increases from Europe and the US. Other
areas in the domestic economy, however, have continued to expand at a good
pace. Construction of both residential and non-residential structures has continued
to grow, a trend likely to continue in the short term at least. The services
sectors of the economy also are generally expanding. Consumer demand is not
growing at the pace seen in the second half of 1997, but that was unlikely
to have been sustained anyway. Apart from the loss of export markets, the main
effect of all this on the Australian economy has so far been mainly to dampen
confidence. Taking that into account, the Bank's assessment is that output
is growing at a moderate but below-trend pace, and that this should continue
in the period immediately ahead.

Inflationary pressures in the economy remain well controlled. The lower exchange
rate will in time add to consumer prices, which up to the end of 1997 benefited
from the impact of a high currency in 1996. Early indications are, however,
that these effects may take a little longer to show up on this occasion than
historical experience might suggest. The international prices of many of Australia's
imports are steady and, in some important cases, the extremely competitive
domestic market may be leading to some compression of profit margins. Vehicle
prices are a case in point. Nonetheless, with wholesale import prices having
risen by about 10 per cent over the past year, some pick-up in consumer prices must be expected.

The Bank's central forecast for underlying inflation (based on a broadly unchanged
exchange rate) is that it will be about 2 per cent over the year to December
1998. During 1999, it is likely that year-ended inflation rates on this basis
will move higher, to around 2½ to 3 per cent. Beyond that period, the
inflation result should mainly reflect trends in the domestic cost structure,
particularly labour costs. These have slowed over the past year, and wage increases
are likely to remain in the 3 to 4 per cent range.

There is more than the usual amount of uncertainty about the economic outlook because
of the potential for further instability in the economies of Asia, and particularly
in their financial markets. Monetary policy has to take this into account as
best it can, and balance it against purely domestic factors. At present, monetary
policy settings are such as to lend support to domestic demand. Interest rates
remain low across the yield curve; credit is freely available and is growing
at a solid pace; and the exchange rate is near the low end of historical experience
against most countries. In the absence of unforeseen developments, this setting
of policy remains appropriate.

International Economic and Financial Developments

Asia

Events in Asia have continued to be the dominant factor influencing financial markets
in Australia in the latest quarter. The Asian crisis moved into a second phase,
with the focus shifting away from the emerging east Asian economies to Japan.
In fact, financial markets in most of the east Asian economies were on a recovery
phase over February, March and April before being unsettled by the deteriorating
economic and financial situation in Japan. Most important has been the weakening
in the yen, which fell against the US dollar from 133 at end March to a low
of 146, before intervention by the US authorities saw it recover sharply (Graph 1).
It has since drifted towards its lows again, amid market concerns about implementation
lags in the government's new stimulatory measures. Bond yields in Japan
fell to 1.125 per cent, equal to the lowest recorded by historians in the past
4,000 years, and well below the level of 1.75 per cent reached by US bonds
in the Great Depression (Graph 2).

Graph 1

Graph 2

While all countries in the region were affected by these developments, the impact
was strongest in countries, including Australia, which had been largely on
the periphery of the earlier troubles. Markets seemed to judge that events
in Japan would make it harder for these countries to avoid the impact of the
turmoil. Some market participants promoted the view that the process would
eventually lead to devaluation by China and the breaking of the Hong Kong dollar's
peg to the US dollar. Not unexpectedly, this saw a great deal of pressure on
Hong Kong markets at times.

Most of the east Asian economies that were at the centre of the first wave of problems
in the second half of 1997 were less affected in this latest phase. In part,
this is because their trade and capital accounts had already adjusted sharply.
Two of the countries in particular – South Korea and Thailand –
weathered the latest regional problems relatively well. Their exchange rates
have appreciated in recent months, to the point where the net depreciation
since the start of their crisis in mid 1997 has been reduced to about 30 per
cent. Short-term interest rates, which had risen to around 25 per cent at the
peak of their crisis in December/January, have fallen sharply. In South Korea,
they are down to 11 per cent, a little below pre-crisis levels (Graph 3).
In Thailand also, rates are around their pre-crisis levels.

Graph 3

In contrast, the economic and financial situation in Indonesia has continued to slip,
with the forces set in train by the initial collapse of the exchange rate last
December/ January proving very destructive in terms of both the political and
economic structure. The appointment of a new President and the subsequent announcement
of a new agreement with the IMF have not yet produced any marked turnaround;
the exchange rate of the rupiah remains around 13,000 to the US dollar, less
than 20 per cent of its pre-crisis level, and short-term interest rates have
risen to about 60 per cent, broadly in line with the rise in inflation.

The one aspect of financial markets in all Asian countries that remains very weak
is share markets. Most countries in the region recorded new lows in share prices
in the latest quarter, with cumulative falls since the middle of 1997 of about
50 per cent (Graph 4).

Graph 4

The economic impact of the regional financial crisis has been seen in some sharp
declines in production and substantial adjustments in current account positions.
The impact has so far been largest in Thailand, Indonesia and Korea. At the
same time, it is becoming clearer that a wider group of countries, which escaped
the worst of the earlier financial turbulence, are now experiencing a significant
economic impact.

For the initial crisis-affected group – the ASEAN-4 and South Korea –
the process of macroeconomic adjustment has been necessarily rapid. The abrupt
reversal of capital flows to these countries meant that their current account
positions had to shift rapidly into surplus. Much of this adjustment took place
through lower imports (Graph 5), and was brought about by very large reductions
in domestic demand. The size of some of the adjustments has been exceptionally
large. Korea's trade position moved by the equivalent of 12 per cent of
GDP, and there were similar movements in Thailand and Indonesia. Domestic demand
in Korea over the year to March declined by around 28 per cent.

Graph 5

In some countries, there are tentative signs that this initial period of rapid adjustment
may have largely run its course. Levels of industrial production in Korea and
Thailand, having declined by around 15–20 per cent from pre-crisis levels,
have been more stable in recent months (Graph 6). Imports are also showing
some signs of stabilising, having fallen by more than 30 per cent in both countries.
Exports from Korea are now recovering strongly in volume terms, although declining
prices mean that, in US dollar terms, they have been flat. In contrast to the
experience of these other countries, the latest data for Indonesia point to
continued economic contraction. National accounts data record a GDP decline
of 17 per cent over the first two quarters of 1998, after a flat performance
during the previous year, and imports have continued to fall rapidly.

Graph 6

The sharp currency depreciations in these countries have led, in varying degrees,
to increased inflation although, in most cases, it remains well contained.
In Korea, the impetus to inflation was concentrated around the end of 1997
and the early months of 1998. More recently, consumer prices in Korea have
stabilised, probably reflecting the very weak demand conditions and surplus
productive capacity in that country. In other countries inflation has come
down from recent peaks but continues to run at a higher rate than in the pre-crisis
period. The largest increase has taken place in Indonesia, where consumer prices
over the year to July rose by around 70 per cent.

The wider impact of the crisis on other countries in the region is now starting to
be seen more clearly. In Hong Kong, GDP declined in the first quarter of 1998
by more than 4 per cent, following a fall of 1½ per cent in the previous
quarter. Singapore has recorded close to zero growth over the past two quarters,
and growth in China and Taiwan has slowed appreciably (Graph 7).

Graph 7

Several factors are contributing to this more general weakening of regional economies.
Declines in asset prices have become widespread across the region, in many
cases amplified by the higher interest rates put in place to resist currency
depreciations. Another factor is loss of export competitiveness. For China
and Hong Kong, which have maintained fixed exchange rates to the US dollar,
there has been a significant loss of competitiveness against producers from
other countries in the region. This is likely to have contributed to the weakening
of their export sales over recent months. To a lesser extent, Singapore and
Taiwan have also lost competitiveness in foreign markets, having had smaller
currency depreciations than those of the initial crisis-affected group. In
addition, the Singaporean economy, which is particularly dependent on intra-regional
trade, is being significantly affected by the downturns in Indonesia and Malaysia.
The extent and likely duration of this general slowing of regional economies
have not yet become clear. Much will depend on developments in Japan, which
is by far the region's largest economy. In that regard, recent developments
are not encouraging.

The Japanese economy continued to weaken in the first half of 1998, prompting the
announcement of further policy measures by the Japanese government. National
accounts data for the first quarter recorded a fall in GDP of 1.3 per cent,
confirming earlier signals of declining demand and output (Graph 8). This
result reflected a significant fall in business investment and a decline in
exports, following strong export growth in 1997.

Graph 8

Most indicators are continuing to point to a difficult environment for Japanese businesses.
According to the Bank of Japan's Tankan survey, business confidence deteriorated further in the June
quarter, to be at levels below the trough reached in the early 1990s. Unsold
inventories are at a high level, and industrial production declined further
in the June quarter. Consumer confidence is also at low levels, and unemployment
has increased to a post-war high of 4.3 per cent.

The deterioration in conditions over the past year has reflected a combination of
circumstances including the decline in intra-regional trade, the substantial
fiscal policy tightening implemented during 1997, and the poor condition of
the Japanese banking system. Weak demand conditions in turn have contributed
to declines in inflation from already-low levels. The level of consumer prices
was almost unchanged over the six months to June, while wholesale prices over
that period declined at an annual rate of around 2 per cent. In these circumstances
of weak demand and flat or falling output prices, it is very difficult for
businesses to generate increased cash flows. The lack of growth in nominal
incomes and spending in the economy, in turn, makes it difficult for businesses
and banks to improve their balance sheets and is reinforcing the reluctance
of Japanese banks to lend. The volume of bank loans outstanding by Japanese
banks has been declining for the past two years.

In this environment of declining demand and financial contraction, there have been
widespread calls to support growth through fiscal expansion and banking-system
restructuring. A fiscal package announced in April contained measures equivalent
to around 3 per cent of GDP, aimed at providing a significant boost to domestic
demand through tax cuts and new spending. More recently, Prime Minister Obuchi
has proposed an additional set of tax cuts to those announced in April. In
June, the government announced a restructuring program for the banking system.
The restructuring plan involves using a new regulatory agency to assess the
viability of all banks, and will provide for the takeover of non-viable banks
by publicly funded ‘bridge banks’. It is proposed that these will
continue to lend to creditworthy borrowers, assist in the disposal of non-performing
assets, and allow the performing assets of failed banks to be transferred to
viable institutions. Public funds for the bridge banks are expected to come
from the ¥30 trillion already allocated for bank recapitalisation,
of which only a small proportion has so far been taken up.

Prospects for the Japanese economy will depend heavily on the effectiveness with
which this program is implemented. International experience suggests that effective
bank recapitalisation is an important condition for any sustained recovery
from a banking crisis of these proportions. It also suggests that, even with
a well-designed restructuring program in place, progress is likely to be slow.
Most observers are expecting output of the Japanese economy to be lower in
1998 than in 1997.

Rest of the world

Outside the Asian region, the crisis has had both positive and negative effects.
The positives are most clearly evident in the United States, where the Asian
crisis, by contributing to a stronger US dollar and falling world commodity
prices, has helped to cap inflationary forces. This has allowed the US Federal
Reserve to sustain lower interest rates and a faster rate of growth in domestic
demand than would have been possible otherwise. US bond yields have fallen
to around 5.4 per cent, much the same as the cash rate, resulting (unusually
for this stage of the economic cycle) in a flat yield curve. The effects on
the US share market, on the other hand, have been mixed: there have been some
benefits from lower interest rates but the profit results of US companies are
increasingly showing signs of adverse impacts from Asian competition. Overall,
US share prices have fallen around 8 per cent from recent peaks (Graph 9).

Graph 9

The US economy has continued its strong gains in the first half of 1998. Real GDP
rose at an annual rate of 4 per cent in the first half of the year, supported
by robust growth in domestic demand. Consumer spending has been buoyed by expanding
job opportunities, increasing real incomes and high levels of wealth. Higher
household wealth, combined with low mortgage interest rates, has, in turn,
boosted housing demand. Business fixed investment has also been brisk, as firms
have taken advantage of conducive financial conditions to expand capacity.

While the strength of domestic final demand seems to have continued, the Asian crisis
is acting to moderate growth. The combined effects of the appreciation of the
dollar and weaker external demand have already seen a sharp increase in the
trade deficit, with both a rapid rise in imports and a fall in exports.

External factors will continue to reduce growth in the remainder of the year, but
it is unclear whether this will be sufficient to forestall inflation risks.
The extraordinary tightness in the labour market has intensified in recent
months; the unemployment rate, at 4.5 per cent in July, has now been below
5 per cent for the past year and earnings growth has picked up accordingly.
So far, however, this has failed to translate into rising consumer price inflation,
because the strength of the US dollar and falling prices for raw materials
have offset higher labour costs.

Economic activity has continued to strengthen in the continental European economies
as the emerging recoveries have become more domestically driven. In Germany,
real GDP rose strongly in the March quarter, as consumers brought forward expenditure
ahead of the April consumption tax increase, and equipment investment rose
strongly. Recent retail sales gains suggest the economy has maintained sufficient
momentum to weather the tax increase, and there have been signs of recovery
in the labour market. In France, real GDP is growing at its fastest pace in
three years, with strong employment gains fuelling consumption. The unemployment
rate has fallen below 12 per cent for the first time since 1996.

In the United Kingdom, growth in domestic demand remains strong, but is being partly
offset by falling net exports, reflecting the appreciation of the pound over
the past two years. The Bank of England raised short-term interest rates by
25 basis points in June to 7½ per cent, citing mounting labour market
pressures and an inflation rate above target as key concerns.

The gathering pace of economic expansion is one reason that European markets have
been least affected by Asia, with share markets in particular remaining stronger
than elsewhere. Europe has also been more preoccupied by the decision on the
group of countries to join the Euro in 1999. The 11 countries joining are (in
order of GDP size) Germany, France, Italy, Spain, the Netherlands, Belgium,
Austria, Finland, Portugal, Ireland and Luxembourg.

Australian Financial Markets

The Australian dollar

The most visible impact from Asia on Australian financial markets has been the fall
in the Australian dollar. It is down from around US75 cents in mid 1997 to
about US60 cents at present (Graph 10). This fall has taken place in two
phases, in line with the two phases of the Asian crisis. The first reflected
mainly the events in east Asia, culminating in the sharp depreciation of the
Australian dollar in late 1997/early January, to around US63 cents. It recovered
from there to around US68 cents by early April, but then fell to a low of US58
cents in June on the back of events in Japan.

Graph 10

Through most of this period the Bank did not intervene in the market, recognising
the underlying economic factors at work and the close connection with events
in Asia. In fact, throughout this period, the Australian dollar, in common
with many other currencies in the region, showed a remarkable tendency to move
very closely with the yen (see Box).

In early June, however, the Australian dollar's fall accelerated, causing it
to decline even against the yen, which was itself falling sharply. Two main
factors were responsible. First, participants in the market began to believe
that the Australian authorities were happy to see the dollar continue to fall.
Second, and perhaps related to these developments, hedge funds stepped up their
profile in the market. This caused a reduction in market liquidity, as other
market players were unwilling to trade on a normal two-way basis while these
funds were selling aggressively.

Against this background, the Reserve Bank intervened in the market, buying $2.6 billion
dollars in local currency during June. The Bank's presence acted as a counterweight
to the hedge funds and restored a normal two-way flow of business although,
on balance, the exchange rate continued to fall, eventually reaching a low
of US58.1 cents. The turning point in the market
came with the intervention by the US Federal Reserve to support the yen exchange
rate; this caused a sharp rise in the yen and the Australian dollar moved up
with it. Subsequently, the Australian dollar continued to recover, even though
the yen steadied, as earlier sellers turned some of their positions. By end
June, the Australian dollar was around US62 cents, a level it remained at or
above during most of July, before falling to around US60 cents in early August
as the yen weakened again.

Market interest rates

The weakness in the exchange rate in June led to a reappraisal within financial markets
about the outlook for monetary policy. This was most clearly reflected in short-term
interest rates, which, for much of the first half of 1998, had continued to
factor in some possibility of an easing in monetary policy. The heightened
pressure on the exchange rate in early June saw the yield on 90-day bills,
which had been a little below the cash rate, rise sharply at one stage to 5.8
per cent. This level implied a strong market expectation that monetary policy
would be tightened. As the exchange rate subsequently moved from its lows,
90-day bill yields returned gradually to around 5.1 per cent (Graph 11).

Graph 11

Box: The Australian Dollar and the Yen

From its float in 1983 until recently, the Australian dollar had traditionally been
regarded by financial markets as being part of the US dollar bloc. As can
be seen in Graph A1, weekly movements of the Australian dollar and the US
dollar through most of this period had a high correlation (averaging 0.74).

Graph A1

The tight link between the Australian and US currencies owed in part to the close
relationship between the Australian and US economies, particularly the similarity
of the cyclical development of GDP in the two countries (Graph A2). The tendency
for dealers to trade the Australian dollar in line with commodity prices,
themselves strongly correlated with US economic growth, may also have contributed
to the link, although the correlation of the Australian dollar with the US
dollar has been significantly higher than its correlation with commodity prices.
Historically there has been no similarity between cyclical movements in GDP
in Australia and Japan (Graph A3).

Graph A2

Graph A3

Since mid 1997, when the float of the Thai baht precipitated the exchange rate crisis
in Asia, there has been increased talk in the market of the Australian dollar
(and several other regional currencies, including the Singapore dollar and
Taiwan dollar) now having moved into a yen bloc. Over this period, there has
been a close relationship between the Australian dollar and the yen, with
the Australian dollar trading in a narrow range between 83 and 88 yen (see
Graphs A4 and A5).

Graph A4

Graph A5

The reasons for this sudden shift in perception are not entirely clear, but are no
doubt related to the view that if the Japanese economy does badly, then the
rest of the Asian region, including Australia, will suffer. One variation
of this is that a falling yen will ‘bring down’ the Chinese yuan,
the Hong Kong dollar and, in turn, a number of their competitors. While Asian
events are having a significant impact on Australia, it needs to be kept in
mind that the trade links to Asia are longstanding and, despite them, the
Australian economy has typically behaved more like the US economy than Asian
economies. This has continued to be the case in the past year. The summary
contained in Table A1 shows the remarkable similarity between Australian and
US economic performance, and the complete lack of similarity between either
of those two countries and Japan.

As can be seen from Graph A6, there have been other periods in the past when the
correlation between the Australian dollar and the yen has risen. But they
have always been short lived. The average correlation between the two currencies
over the post-float period has been close to zero.

Graph A6

Looked at another way, since the mid 1980s, the yen has been through four broad phases:
it appreciated from 1984 through to 1988, then depreciated up until early
1990, resumed its appreciation between 1990 and mid 1995, and then began to
depreciate again. In each of these phases until mid 1997, the Australian dollar showed no sustained tendency
to move with the yen.

Table A2: Movements in the Australian Dollar and the Yen

Against US Dollar; per cent

Yen

Australian Dollar

Feb 1985 – Jan 1988

116

3

Jan 1988 – Apr 1990

−24

4

Apr 1990 – Apr 1995

99

−2

Apr 1995 – June 1997

−28

3

While it is understandable that the exchange rate of
the Australian dollar reflects developments in Asia,
the closeness of the link to the yen that has developed
over the past year seems difficult to justify on the
behaviour of the two economies. It is possible that
the increased correlation is simply a short-term phenomenon,
as experienced on several occasions in the past, rather
than the start of a new pattern. For the correlation
to be sustained, there would need to be a greater correlation
in the economic performance of the two economies, and
at this stage there is no evidence that this will be
the case.

Money markets in Australia were also affected in the
June quarter by the introduction of real-time gross
settlement (RTGS) for interbank payments in Australia,
which resulted in a temporary rise in banks' demand
for liquid funds. This saw the cash rate move above
its target of 5 per cent for a time, and the yield on
Treasury Notes, which are eligible for purchase by the
Reserve Bank in the course of its market operations,
move to 50 basis points below that for bank
bills (from normally about 10 basis points below). As banks grew more accustomed
to operating under RTGS, these pressures subsided.

The pressures on market yields arising from the fall in the exchange rate were less
apparent in the bond market than in short-term yields, although bond yields
did rise to some extent in June. This rise partly reversed earlier declines,
which had reflected a number of factors: the expected negative impact of
the Asian situation on the local economy, associated concerns about the
possibility of global deflation, and the projected fall in the stock of
bonds on issue reflecting the expected run of Budget surpluses and the
proposed sale of the remainder of Telstra. After reaching a low of 5.3
per cent in early June, the yield on 10-year bonds rose to 5.8 per cent
by mid June, then moved back to around 5.5 per cent subsequently (Graph 12).

Graph 12

At their low point in early June, bond yields in Australia were below yields in the
United States, but the rise in yields associated with the fall in the exchange
rate again lifted them above US yields. In early August, the margin of
10-year bonds in Australia over 10-year US Treasuries was about 20 basis
points, still well below the historical norm. The rise in Australian short-term
interest rates relative to those in the United States was more pronounced,
but has now been largely reversed.

The share market

The Australian share market has been volatile in recent months. After rising quite
strongly in the first four months of 1998, in line with the lift in world
share markets generally, it fell by over 10 per cent by mid June. The main
factors underlying this fall were renewed pessimism about Asia, due to
the problems being experienced by Japan, and the turn in expectations about
interest rates in Australia following the fall in the exchange rate. Subsequently,
calmer conditions returned in Australia, and helped by the US market reaching
new highs in July, Australian share prices recovered. The rise, however,
was narrowly based, being attributable mainly to share prices of a small
number of large companies. Subsequent weakness in world share markets over
late July and early August, reflecting renewed concerns about Asian markets,
saw share prices in Australia return to close to their June lows. Prices
of resource stocks have been weaker than average, as markets have judged
that prospects for profits of resources companies have been particularly
weakened by the malaise in Asia. The index of share prices in the resources
sector has fallen by 18 per cent since April, compared with a fall in the All Industrials of 2 per cent.

Domestic Economic Activity

Growth in output of the Australian economy is now slowing from the solid pace recorded
during 1997 and into the early part of 1998. Over the year to the March
quarter, real output increased by a little under 5 per cent, and growth
in the non-farm economy was somewhat stronger than that. There have been
a number of signs that the economy is now easing back to a more moderate
pace of growth. According to the national accounts, there was a sharp slowing
in private spending in the March quarter, while an unusually large volume
of output in the quarter was absorbed by stockbuilding (Table 1).
Although more recent indicators suggest that the slowing of private spending
depicted in the accounts is exaggerated, the indicators generally confirm
the economy's transition from above-trend to below-trend rates of growth.
The labour market, meanwhile, continues to benefit from the economy's
strong performance over 1997 and early 1998, and unemployment remains below
the levels of a year ago.

A sharp turnaround in the external sector, evident in weakening export volumes and
declining commodity prices, has been the major dampening influence on growth.
As noted above, the contractionary impulse arising from the Asian crisis
has occurred in two stages – an initial, rapid contraction in the
economies first affected by the regional financial instability, and a more
delayed slowing of other economies in the region. Much of the impact on
Australia's exports to the first group of countries has probably now
taken place, and there is evidence of a growing diversification of exports
to other destinations. However, the more recent downturns in other regional
economies, and particularly Japan, will have some further dampening influence.
The deteriorating external situation has also had an adverse impact on
business and consumer confidence. The Australian economy is likely to experience
a period of below-trend growth while these factors remain in place.

Household income and expenditure

Retail spending showed a small decline in real terms in the June quarter, to be 2.8
per cent higher than a year ago. Over the first half of 1998 retail trade
has shown almost no net increase in real terms, following the strong growth
recorded in the second half of 1997. The result for the month of June,
a fall of 0.8 per cent, incorporates a substantial decline in spending
in department stores; this may partly reflect recent changes to the timing
of mid-year sales, as there was a similar fall recorded the previous June,
followed by a strong bounce-back the next month (Graph 13).

Graph 13

Sales of motor vehicles have again posted some very rapid growth, after easing back
a little in the early part of 1998. In June, motor vehicle registrations
jumped by 17 per cent; this occurred alongside a rise of 22 per cent in
car imports in the month. The renewed growth in sales has been supported
by further discounting by retailers and reductions in imported car prices.
For 1997/98 as a whole, passenger vehicle registrations were, at over 650,000, the highest on record. It is
possible that the increases in car sales occurring at present, by absorbing
a higher proportion of disposable incomes, are having a dampening effect
on sales of other durable goods.

Consumer sentiment, according to the Melbourne Institute survey, declined through
the first half of 1998, although it remains above long-run average levels.
Consumers appear to be becoming more concerned about the outlook for the
economy and the outlook for unemployment (Graph 14). Their responses
are clearly sensitive to the news which is released around the time the
survey is being taken but, in broad terms, appear to reflect the likelihood
that the economy will grow more slowly in 1998 than it did in 1997. In
contrast to sentiment about the economy as a whole, there has been little
decline in measures of consumers' perceptions of their own financial
situation, which remain well above longer-term averages.

Graph 14

One factor which should help underpin consumer spending in the latter half of 1998
is the AMP demutualisation. Insofar as policyholders perceive their allocation
of shares as amounting to a windfall gain, they are likely to use a proportion
of the proceeds from the demutualisation to boost spending. With the market
price of AMP shares towards the top end of earlier expectations, the addition
to household wealth will be somewhat larger than was initially estimated.
To some extent, however, the effect on spending may be dampened by current
consumer concerns about the outlook for the domestic economy, particularly
given that household saving has been declining recently. On balance, our
earlier estimate that the demutualisation would boost consumer spending
by a few tenths of a per cent of GDP remains plausible (for further details,
see the May 1998 Semi-Annual Statement, Box B).

The housing market

Housing construction activity has increased strongly over the past 18 months, supported
by high levels of affordability. In the March quarter, the number of housing
commencements was 10.1 per cent higher than a year earlier, and building
approvals data point to a further solid increase in the June quarter. Growth
in activity has been boosted by continued increases in the value of the
average new dwelling constructed, and by strong growth in spending on alterations
and additions.

Notwithstanding this recent strength, the likely extent of future expansion in the
current housing upswing is difficult to gauge, with forward indicators
of housing demand giving conflicting signals. After increasing strongly
during much of 1997, loan approvals for housing appeared to level out in
the early months of this year, before showing a strong further rise in
June (Graph 15). The increase in loan approvals in June may have partly
reflected efforts by borrowers to take advantage of existing low interest
rates, amidst widespread talk that intermediaries' interest rates might
rise. These concerns may have brought forward some demand for loans, as
well as encouraging a strong increase in refinancing as borrowers shifted
from floating to fixed-rate loans. As discussed in detail in the section
on Financial Conditions below, there were some small increases in fixed
housing loan rates, which reflected increased funding costs in financial
markets.

Graph 15

Local government building approvals, meanwhile, have continued on a strong upward
trend, with growth in the alterations and additions component particularly
pronounced. The normal pattern is that trends in housing finance lead those
in building approvals, and so it would be unusual for the current strong
growth in building approvals to continue without some renewed growth in
finance. A plausible interpretation of these trends is that the housing
upswing may be maturing, particularly given that the rate of new construction
is approaching a level somewhere near the trend rate of expansion in demand
for new housing. This would also be consistent with other evidence that
demand conditions in the market for existing housing are now easing a little
in some areas.

Recent trends in house prices are pointing to an easing of excess demand in those
areas where it had initially been concentrated, particularly in the inner
suburbs of Sydney and Melbourne. After a period of rapid growth during
1997, house-price increases in these inner city areas have eased considerably
in recent months. More moderate upward pressures on prices are now working
their way across a wider area in the middle and outer suburbs of Sydney
and Melbourne, as well as becoming evident in a number of the other capital
cities. Available indicators of rental rates and vacancies of residential
property are volatile and vary considerably across capital cities but,
in general, they provide tentative signs of a mild easing of growth in
rents; vacancy rates have picked up a little in some cities, but they remain
low. Together, the trends in house prices, rents and vacancies provide
little evidence of a significant build-up of either excess demand or excess
supply in the housing market at present. Conditions would seem supportive
of continued, although somewhat more moderate, growth in housing investment
in the period ahead. Given the low level of interest rates, spending on
alterations and additions seems likely to remain strong.

The business sector

Production increased strongly in the March quarter following good growth through
1997. A significant part of the March quarter increase in output, however,
was recorded as being absorbed in unsold stocks, and the interpretation
of this result has an important bearing on the business outlook for later
in the year. Some increase in stocks in the March quarter was expected
as, according to the national accounts, stocks had been run down over 1997,
and surveys had been pointing to a desire by businesses to re-build stocks.
A detailed examination of stocks-to-sales ratios at an industry level
shows that the increase in stocks in the March quarter largely returned
these ratios to around their average levels of recent periods (Graph 16).
It is also possible that the large estimate for stockbuilding will be subject
to revision – the pattern over the 1990s has been that unusually
large initial estimates of the change in stocks have tended to be revised
to show less extreme movements. Nevertheless, the magnitude of the increase
in stocks in the quarter is, at least in part, suggestive of some unintended
stockbuilding having taken place.

Graph 16

Business surveys have pointed to weaker conditions in the June and September quarters.
This appears to be mainly linked to the ongoing crisis in Asia, which has
had a large direct effect on export sales and has reduced business confidence.
Almost two-thirds of respondents to the NAB Survey of non-farm businesses
expect their firms to be affected by developments in the Asian region in
the next 12 months. Averaged across all respondents, total sales are expected
to be 2 per cent lower than they would otherwise have been on account of
developments in Asia. Business confidence, as recorded in the June quarter
NAB survey, has declined to a level slightly below the most recent trough
reached in March 1996. The decline in this measure of business confidence
has, however, been somewhat more marked than the declines in indicators
of firms' employment and capital expenditure plans recorded in the
same survey (Graph 17). In this respect, there is a parallel with
consumer survey results, which suggest that consumers are more pessimistic
about the economy as a whole than about their own circumstances. Other
business surveys are more pessimistic, particularly those relating specifically
to the manufacturing sector such as the ACCI-Westpac and Colonial State
Bank surveys.

Graph 17

The greater deterioration in confidence in the manufacturing sector is likely to
reflect that sector's relatively high exposure to international trade
and the loss of export sales to the east Asian region. Employment and profitability
in manufacturing have been weaker than in other industries over the past
year, with employment recording a decline. As discussed in detail in the
section on Balance of Payments below, manufacturing is likely to be one
of the areas in which exporters have greatest difficulty in the short term
in diversifying into alternative markets to compensate for reduced sales
in Asia. The manufacturing-based surveys have been pointing to significant
declines in export sales, and balance of payments data confirm the weakness
in manufacturing exports over much of the past year, although they picked
up in the June quarter. The surveys also suggest a significant decline
in manufacturers' investment intentions (generally presenting a more
pessimistic outlook in this regard than the ABS capital expenditure survey,
discussed below).

Total profitability of the corporate sector, as measured by gross operating surplus,
has been gradually declining as a share of GDP since the peak reached in
1996, and is now, at 15 per cent, around its decade average. The recent
depreciation of the Australian dollar and consequent increase in Australian-dollar
commodity prices would generally imply an increase in profits for mining
companies. However, many large companies had hedged the $A/US$ rate prior
to the exchange-rate decline, and hence will not receive any boost to profits,
at least in the short term. In addition, some companies have a natural
hedge, earning most of their income in US dollars but also incurring a
high proportion of their costs in US dollars. Therefore, benefits to these
companies may also be smaller than in other cases.

If the recent deterioration in business sentiment is to have a significant effect
on real activity, it would do so by altering firms' investment and
employment plans. Over the past five years, investment expenditure on equipment
has grown very strongly. Recent data, however, suggest some reduction in
the pace of growth. Estimates from the latest ABS capital expenditure survey
for 1997/98 suggest real growth (in annually chained terms) of around 5 per cent over the year to the June quarter,
compared with 10 per cent over the preceding year. Estimates for 1998/99
are pointing to a subdued outlook for this type of investment. Based on
average realisation ratios, the survey would imply only moderate growth
in nominal terms for the year, and roughly flat equipment investment in
real terms. This expectation, recorded in the survey conducted in late
April and early May, represents a downward revision to the previous outlook
recorded three months earlier. Within the total, expectations in the manufacturing
sector have been revised upward, although this was from a low level and,
as noted above, the manufacturing-based business surveys continue to give
a very pessimistic reading.

In contrast to these expectations for investment in equipment, the capital expenditure
survey points to a stronger outlook for investment in buildings and structures.
This impression is supported by a recent pick-up in private non-residential
building approvals. While non-residential approvals are extremely volatile,
they have been quite strong in the June quarter, regaining levels recorded
in the latter part of 1997 (Graph 18). If sustained, this recent strength
in approvals would support reasonably firm growth in construction activity
over 1998/99. It also appears that there is quite a large stock of work
yet-to-be-done, which should also help underpin further growth in construction
activity. This is the case both for non-residential buildings and for engineering
construction projects, such as private-sector infrastructure developments.

Graph 18

Non-residential construction work is typically very lumpy, and the recent increase
in commencements has been concentrated mainly in office, hotel and recreational
projects. According to the latest Access Economics Property Monitor, office
and hotel projects currently under construction and under consideration
are heavily concentrated in New South Wales, although other types of project
are more evenly spread geographically. This pattern appears broadly consistent
with information on office rents and vacancy rates, which suggest that
demand for office space is stronger in New South Wales than elsewhere.
The concentration of hotel projects in Sydney, in particular, largely reflects
projects which are driven by the expected increase in tourism associated
with the Olympic Games. The Property Monitor gives little evidence so far
of construction projects being cancelled in the wake of recent declines
in business confidence. Between the March and June surveys, plans for only
one large development were placed on hold and only a couple of projects
were downgraded; the stock of projects under consideration in June remained
around the level of a year ago.

Over the past few years, private-sector businesses have funded relatively more of
their activities in the form of debt finance. This has been reflected in
an increasing ratio of corporate debt to equity. More recently the rate
of growth of corporate borrowing from domestic financial institutions has
declined, and in the March quarter corporates retired a large sum of foreign
debt. Coupled with ongoing equity raisings, this reduced the overall debt
to equity ratio in the March quarter. This reversal of the upward trend
in corporate leverage may prove to be temporary, however, with a number
of large companies recently undertaking share buy-backs.

The labour market

Employment has continued to post solid gains in recent months, following the strong
growth in output over 1997 and into the early months of 1998. In July,
the level of employment stood slightly more than 2 per cent higher than
a year earlier (Graph 19). Full-time employment has been increasing
at around the same rate as the total over the past year, recovering from
an earlier period of around 18 months without growth. Much of the growth
in employment over the past year has been in private-sector service industries,
particularly in property and business services, while there have been declines
in employment in manufacturing and the public sector. The stronger labour
market conditions overall have been reflected in a fall in the unemployment
rate over the past year. In July, the unemployment rate was 8.3 per cent,
compared with 8.7 per cent a year earlier.

Graph 19

Labour productivity has continued to grow rapidly. According to the latest national
accounts, labour productivity per hour worked over the year to the March
quarter 1998 was exceptionally strong, increasing by almost 4 per cent. To some extent this result was
boosted by differences in timing between the recent increases in output
and employment growth, with the pick-up in output growth preceding that
in employment (see below); it also appears to be based on implausibly low
estimates of the increase in hours worked. Even allowing for these factors,
however, it is clear that rapid productivity growth remains an important
feature of the current period of economic expansion. Since the start of
the economic recovery in 1991, annual productivity growth has averaged
just under 2 per cent.

Short-term fluctuations in the rate of employment growth have typically lagged behind
those in aggregate output (Graph 20). In broad terms, the recent trends
in employment have continued that pattern, with the stronger employment
growth that started in the second half of 1997 coming somewhat later than
the initial pick-up in output growth. Although the relationship between
these two variables is not precise, past behaviour would suggest some additional
impetus to employment still to come from the economy's recent strength,
before the current slowing in output growth begins to affect the labour
market. However, the unknown factor in the present outlook is the extent
to which businesses may adjust their hiring plans in light of their more
pessimistic assessments of economic prospects. It is possible that, given
the publicity surrounding developments in Asia and their adverse effect
on confidence, businesses may be somewhat more cautious in their hiring
plans than would normally be expected following a strong period of economic
growth.

Graph 20

Indicators of prospective labour demand are providing mixed signals at present. According
to the NAB business survey, there has been a moderate decline in firms'
near-term hiring intentions over the past six months, occurring alongside
the more general deterioration in business confidence. Vacancies indicators,
however, offer a stronger picture (Graph 21). Both the ANZ job-ads
series and the DEETYA Skilled Vacancy Index continue to rise, and are respectively
15 and 22 per cent higher than a year ago. Even stronger growth has been
recorded in the ABS vacancies series, which has risen by 28 per cent over
the past year, the bulk of this in the past two quarters.

Graph 21

Balance of Payments

The impact of the economic problems in the Asian region are now clearly evident in
Australia's external accounts. These events have contributed to a decline
in the volume of exports, a fall in Australia's terms of trade and
a widening of the current account deficit. Growth in imports remained quite
strong in the first half of 1998, showing a sharp increase in June after
a few months when they had appeared to be levelling out.

After growing solidly through much of 1997, the volume of exports of goods and services
fell by 0.8 per cent in the December quarter and by a further 1.7 per cent
in the March quarter, after adjusting for RBA gold transactions. In an
underlying sense, the slowing in export growth was probably even more marked,
as exports of non-official gold were unusually strong in these two quarters,
reflecting the re-export of gold imports from a number of the east Asian
countries. The observed weakening in export growth reflected both the direct
effect of weakness in demand from the Asian region and the effect of lower
farm production. Reasonably solid growth in export volumes appears to have
occurred in the June quarter.

Exports of services and manufactures have been the areas most adversely affected
by developments in the east Asian region. After falling by nearly 8 per
cent in the December quarter, the volume of services exports was flat in
the March quarter, and appears to have risen marginally in the June quarter.
Manufactured exports fell by 2½ per cent in the second half of 1997
and by a further 4 per cent in the March quarter, but appear to have rebounded
in the June quarter. The export of several ferries boosted the June quarter
growth but, even excluding these, manufactured exports probably increased
by over 3 per cent in the quarter.

Tables 2 and 3 provide an overview of these developments at a regional level. They
show that over the year to the June quarter, the value of manufactured
exports to east Asia fell by around 15 per cent, while overseas arrivals
from east Asia (a good indicator of tourist trade) fell by around 10 per
cent. Developments in east Asian markets have thus had a significant impact
on total exports of manufactures and services from Australia. These tables
also illustrate, however, that exporters have made some gains in sales
to other countries; over the past year, growth in exports of manufactures
and services to many countries outside the Asian region have been stronger
than trend growth rates recorded earlier in the 1990s.

Table 2: Manufactured Exports by Destination

Annual percentage change; values

Average
1990–1995

Year to
June quarter 1998

East Asia (incl. Japan)

20.6

−14.6

of which:

Troubled Asia

22.8

−48.2

– Korea

29.0

−52.7

– Indonesia

15.0

−55.9

– Thailand

23.6

−44.6

– Malaysia

25.2

−47.2

– Philippines

23.7

−24.5

Japan

10.1

0.1

Other east Asia

23.3

13.8

United States and Europe

10.4

20.5

New Zealand

16.4

0.0

Rest of the world

39.9

38.2

Total

16.3

6.5

Table 3: Overseas Arrivals by Country

Annual percentage change

Average
1990–1995

Year to
June quarter 1998

East Asia (incl. Japan)

18.4

−10.1

of which:

Troubled Asia

32.3

−49.0

– Korea

64.4

−78.6

– Indonesia

31.5

−40.0

– Thailand

32.7

−57.7

– Malaysia

18.4

−21.0

– Philippines

15.0

−11.0

Japan

10.3

0.5

Other east Asia

24.0

22.1

United States and Europe

5.5

12.2

New Zealand

5.2

14.5

Rest of the world

8.8

16.2

Total

11.0

1.2

A sharp weakening in rural exports in the December and March quarters also contributed
to the weakening in total export growth. Rural exports fell by over 10
per cent in the March quarter, after having fallen by nearly 4 per cent
in the December quarter, and they appear to have been broadly flat in the
June quarter. This weakness can be explained largely by a decline in farm
production from unusually high levels in 1996/97. Weakness in demand in
the Asian countries has also contributed to the weakening in rural exports,
as exports of some commodities, such as live cattle and wool, have been
particularly concentrated in Asia. In general, however, exporters of many
rural goods have been able to find alternative markets for their products
to compensate for the loss in demand from Asia.

This diversion has been particularly clear in the case of resources (Graph 22).
These relatively homogenous commodities are typically sold into world markets.
The available data suggest that lost sales into Asia have been completely
offset by increased sales elsewhere, particularly in Europe. As a result,
growth in resource export volumes (excluding gold) over the year to June
was around 6 per cent, the same as over the preceding 12 months, and close to the average rate of
growth in the 1990s.

Graph 22

Volatility in the export data, combined with a lack of information about country-specific
price developments, imply that month-by-month developments have to be interpreted
with care. However, tentative signs are emerging that the worst of the
direct effect on Australia of the contraction in demand in South Korea
and the ASEAN countries may have already passed. Exports to these countries
appear to have stabilised in recent months (albeit at much-reduced levels),
while exports to other regions outside Asia have continued to pick up,
reflecting both solid demand and improvements in the competitive position
of Australian exporters (Graph 23).

Graph 23

Import demand has remained quite strong in the first half of 1998 although, prior
to the sharp increase recorded in June, nominal spending on imports had
appeared to be easing. A big part of the latest rise was accounted for
by motor vehicles, but there was also significant growth in imports of
intermediate goods. The recent strength of imports supports the assessment
that domestic demand continues to expand at a reasonable pace. There is
little evidence of a widespread acceleration in imports from the troubled
Asian economies, although there have been significant increases in certain
categories, notably motor vehicles, gold and jewellery – the latter
two probably destined for re-export. Overseas departures to many of the
troubled Asian economies have also picked up markedly over the past year.

The net effect of these external developments has been to increase the size of the
current account deficit (Graph 24). In the March quarter, the current
account deficit was 5.4 per cent of GDP, driven largely by a widening in
the trade deficit to 1.8 per cent of GDP. In the June quarter, the trade
deficit has declined a little, and the current account deficit may have
also declined, depending on the size of the net income deficit.

Graph 24

It is notable that the exchange rate depreciation has had little valuation effect
on the net income deficit. A bit more than half of the gross external debt
is denominated in foreign currencies. It, and the foreign currency debt
servicing payments, are therefore subject to valuation effects when the
exchange rate changes; currency depreciation increases the debt-servicing
costs in Australian dollar terms. However, the effect this has on the net
income deficit is being roughly offset by the corresponding valuation impact
on foreign assets, since these are of similar magnitude to the foreign-currency-denominated
component of external debt. In the March quarter, valuation effects meant
that the net income deficit actually narrowed slightly, to $5.0 billion (3.6 per cent of GDP).

Net foreign liabilities rose in the March quarter, with a $6.9 billion increase taking
the stock of net foreign liabilities to $323.0 billion (59.9 per cent of
GDP); net foreign debt now stands at $224.5 billion (41.6 per cent of GDP).
The ratio of income payments to exports remains near its average over the
past two decades, at 17.9 per cent.

Commodity prices

After stabilising in the early months of 1998, commodity prices weakened during the
June quarter as evidence emerged of a further deterioration in demand in
Asia. In US dollar terms, Australia's commodity prices are now around
18 per cent below the peak recorded in the early months of 1997, prior
to the onset of the Asian crisis. In SDR terms, the decline has been about
15 per cent (Graph 25). These price falls have been spread across
most components, but have continued to be most pronounced for base metals
and rural goods. Contract prices of bulk commodities have so far been unaffected
by significant price falls, but spot prices have now fallen well below
these contract prices in some cases.

Graph 25

The further recent weakening in the outlook for Asia, particularly outside the initial
crisis-affected group, appears to have specifically affected the outlook
for wool and base metals. Wool prices have continued to fall sharply, and
are now 18.5 per cent below levels of a year ago in Australian dollar terms,
inducing some wool producers to switch to prime lamb production. The weakening
in base metals prices in recent months has been driven by concern over
falling demand in Asia, particularly in Japan.

Influences other than the Asian events also appear to be having a dampening effect
on some commodity prices. Oil prices, although fairly stable for the past
couple of months, remain nearly 30 per cent lower than levels of a year
ago in US dollar terms because of high production levels. In March, members
of OPEC agreed to cut production by around 2.6 million barrels a day in
order to support prices. Falling wheat prices in recent months mostly reflect
increases in world stock levels; stocks have increased over the past year
due to the combination of good harvests in many regions and weaker world
demand.

Despite the continued weakness in commodity markets, the further decline in the Australian
dollar against the major international currencies has meant that, in domestic-currency
terms, commodity prices have remained roughly stable in recent months.
They are slightly above their average level of the past five years or so.

Financial Conditions

Intermediaries' interest rates

With the Reserve Bank's cash rate target unchanged since July 1997, there have
been few changes in interest rates on variable-rate loans in recent months.
However, recent volatility in capital market yields has caused some financial
intermediaries to adjust rates on fixed-rate loans.

Banks announced increases in June of up to 35 basis points in the interest rate on
three-year fixed-rate housing loans, taking this rate to 6.85 per cent.
Even so, this rate remains 1.9 percentage points under the previous cyclical
low early in 1994, reflecting the trend decline in bond yields over recent
years. With fixed-rate loans at historical lows, and markets focusing on
the possibility of higher interest rates, the proportion of fixed-rate
borrowers rose to around 25 per cent in June, compared to 15 per cent in
the previous month.

Interest rates on variable-rate loans, which tend to be priced from the cash rate,
have not changed in recent months. Indicator rates on standard variable-rate
housing loans from banks remain around 6.7 per cent, where they have been
since August 1997, while variable lending rates of mortgage managers are
40 basis points lower at 6.3 per cent. This period of stability in housing
interest rates suggests that the period of intense competition in the housing
market, driven by mortgage managers' quest to raise market share, has
run its course, at least for the time being.

Rates charged on small business fixed-rate loans also rose in June, although some
of this was reversed in July. The average indicator rate on three-year
fixed-rate loans to small business is up by a net 20 basis points, to 7.2 per cent, over the two months.

Perhaps of more significance, competition in small business finance has intensified
over the past year, as banks have reduced indicator rates on variable-rate
loans on mainstream lending products and offered products with risk margins
linked closely to the type of security that borrowers offer. The average
indicator rate for overdrafts fell by about one percentage point over March
and April, to 7.7 per cent, even though there was no change in monetary
policy. The predominant indicator rates on term loans and overdrafts secured
by residential property are 6.9 and 7.2 per cent respectively. These rates
are the lowest for ‘widely available’ small business products
since the mid 1960s (Graph 26).

Graph 26

In the March quarter, the average interest rate on small business variable-rate loans,
incorporating customer risk margins, was 9.4 per cent. These figures do
not yet capture the latest reductions in small business indicator rates,
which were announced late in March and early in April. Banks' margins
on small business lending, which have narrowed since mid 1997, might narrow
further in figures for the June quarter and beyond as recent reductions
in indicator rates begin to affect the figures.

While there has been no widespread move to lower indicator rates on variable-rate
loans for large business, two banks also reduced these rates when they
announced reductions in small business rates. While the average indicator
rate on large business variable-rate loans, at 8.0 per cent, is now higher
than the corresponding rate for small businesses, the all-up borrowing
cost to large business remains lower than for small businesses since customer
risk margins for the former are, on average, finer than those for the latter.
This is evident in the average interest rate paid by large businesses for
variable-rate loans, which was 7.9 per cent in March 1998.

Some signs of competition among banks for personal lending have also become evident,
especially for secured and unsecured fixed-rate personal instalment loans.
In recent months, the interest rate on secured fixed-rate personal loans
has been reduced by 2.1 percentage points to 9.9 per cent, and that for
unsecured fixed-rate loans has fallen by 1.2 percentage points to 11.1
per cent. There has been no change to interest rates generally either on
variable-rate personal loans or credit cards since September 1997, following
the last easing in monetary policy. Some banks have made some special offers
available on credit cards to new customers.

Banks' interest spreads

With the growing competition in lending markets, banks' interest spreads have
narrowed.[1] In the period of financial deregulation in Australia, dating from the early
1980s, the average spread of major banks has declined from about 5.0 per
cent to 3.2 per cent in 1998. The gap that emerged in the early 1990s between
the spread on performing assets and that on total assets reflected the
impact of banks' bad loans on profits in that period. The high level
of bad loans worked to reduce the overall spread, while banks sought to
compensate by increasing the spread on performing loans. After a period
of adjustment in 1993 and 1994, a clear downward trend in both measures
of spread resumed (Graph 27).

Graph 27

The downward trend in recent years reflects a larger fall in the average interest
rate received by banks than in the average interest rate paid. The former
effect reflects the narrowing of margins on housing and small business
loans: the rate on standard variable rate housing loans has fallen by 1.3
percentage points more than the cash rate since mid 1996; in 1998, the
average variable-rate on small business loans has fallen by 0.7 of a percentage
point relative to the cash rate. Banks' cost of funds has fallen by
less than the reduction in the overnight cash rate, in part, because rates
paid by banks on some deposits, particularly transaction accounts, were
already low during the recent phase of easing in monetary policy and could
not be reduced pari passu with the cash rate.

Financial intermediation

Total credit provided to the private sector by financial intermediaries grew at an
annual rate of 9.6 per cent over the six months to June (Table 4).
While still a robust rate of increase in an economy in which nominal incomes
are growing at around 6 per cent, this represents a moderate slowdown in
the pace of financial intermediation from rates recorded in the second
half of last year. Within the total, credit to households has picked up
slightly, while the rate of expansion of business credit has declined.
After the strong pick-up seen in the second half of 1997, business credit
is now growing at a more moderate pace.

Table 4: Financial Aggregates

Seasonally and break-adjusted annualised growth rates; per cent

Six months to:

June 1997

December 1997

June 1998

Total credit

10.3

12.6

9.6

– Personal

9.0

16.6

14.3

– Housing

12.2

9.8

12.1

– Business

9.1

14.2

6.7

Currency

7.6

7.4

6.7

M1

19.6

11.3

10.8

M3

11.7

2.8

8.3

Broad money

11.1

4.8

7.2

The growth in housing credit outstanding reflects the net effect of new lending and
loan repayments. The increases in new loan approvals recorded through most
of 1997 did not lead to an increased rate of growth in loans outstanding,
because principal repayments were increasing at the same time. Households
were responding to declining interest rates by paying off their loans more
quickly rather than reducing loan payments. In recent months, as discussed
in the section on Domestic Economic Activity above, housing loan approvals
have stabilised after the strong growth recorded earlier, but they remain
at a high enough level to generate continued strong growth in the value
of loans outstanding.

Following a period of weakness, growth in the broader deposit-based aggregates, M3
and broad money, has picked up in the past few months. The increase in
broad-money growth, to an annualised rate of around 7 per cent over the six months to June, brings
it more into line with the growth in credit. This followed a period in
the second half of 1997 when banks had been funding a significant part
of their credit expansion from other sources, principally offshore borrowing
and a reduction in holdings of government securities. Growth in currency
over the six months to June was marginally lower than over the previous
six months, and, on the most recent figures, appears to have eased a little
further, possibly reflecting moderation in the growth of consumer spending.

Funds under management grew strongly in the March quarter, to continue the trend
seen over the past three years. There is little evidence of this trend
slowing in the near term. Over the year to the March quarter, growth in
total assets of managed funds has been strongest in the cash management
and public unit trust sectors (Table 5). Assets of equity trusts have
grown particularly strongly, to be up by 8 per cent in the March quarter
and by nearly 40 per cent over the year. Underpinned by mandatory contributions,
assets managed by superannuation funds continue to grow strongly. Valuation
effects have contributed around half of the asset growth over the past
year in life offices and superannuation funds. Funds managed by friendly
societies continue to contract.

Table 5: Assets of Managed Funds

Percentage change

Year to
March 1996

Year to
March 1997

Year to
March 1998

March quarter
1998

Cash management trusts

24.7

41.5

34.8

4.2

Unit trusts

16.5

29.2

31.7

5.5

of which:

– Property trusts

13.6

21.8

23.0

0.9

– Equity trusts

23.2

35.5

38.4

8.1

– Mortgage trusts

26.8

31.8

30.3

4.1

Life offices

8.9

8.9

9.9

0.9

Superannuation funds

17.5

15.5

20.9

4.2

Total

13.4

14.8

18.3

3.1

Sources: ABS Cat. Nos 5655.0 and 5645.0.

The growth of funds under management in recent years has been encouraged by the high
average rates of return yielded by these investments relative to those
that can be earned on traditional savings vehicles. While the volume of
bank fixed deposits has been little changed over the past 18 months, funds
under management have increased by $94 billion. The search for higher returns
has also resulted in a sharp increase in direct investment in the share
market by households. A recent survey by the Australian Stock Exchange
found that around 29 per cent of the adult population directly
owned shares, up from 16 per cent four years ago and 9 per cent a decade
ago. This proportion will increase further following the strong retail
exposure to the United Energy, AMP and NSW TAB floats subsequent to the survey. Reflecting this change, household
income derived from dividends has almost doubled over the past four years.

Household balance sheets

While household saving rates have been fairly stable throughout the 1990s, household
assets and liabilities have expanded rapidly, increasing as a proportion
of household disposable income. This accumulation in assets and liabilities
has seen marked changes in the composition of household balance sheets.
As households have simultaneously increased their debt levels and equity
holdings, they are now much more exposed to changes in interest rates and
equity prices than has been the case in previous cycles.

Despite the increasing exposure to financial markets, household sector balance sheets
remain strong, with their aggregate net financial assets rising by around
14 per cent over the year to the March quarter 1998. In the March quarter,
households' liquid financial assets (excluding superannuation) were
around 125 per cent of household disposable income, comfortably exceeding
their financial liabilities, which were around 100 per cent of household
disposable income. The ratio of total household debt to the value of the
housing stock has, until recently, been increasing, but remains a little
below the peak of the late 1980s (Graph 28). In the past year, house
price increases have reduced this ratio somewhat, suggesting that there
remains a substantial reserve of housing equity acting as collateral on
bank loans. Of course, these aggregate indicators hide some significant
dispersion in the pattern of asset and liability holdings across households.
Certain categories of households, notably recent home-buyers, will have
considerably greater debt exposures than the average.

Graph 28

Inflation Trends and Prospects

Recent developments in inflation

Consumer prices

Inflation remains low and has risen only marginally from the trough it reached at
the end of 1997. In underlying terms, consumer prices rose by 0.4 per cent
in the June quarter to be 1.6 per cent higher over the year (Graph 29). At a quarterly rate, the
increases in the March and June quarters (0.5 and 0.4 per cent) show a
small pick-up after a succession of increases of 0.3 per cent in 1997.
The small increase in inflation in the past two quarters mainly reflects
the withdrawal of the earlier disinflationary impact from declining import
prices. As discussed below, the recent currency depreciation can be expected
in time to give a significant boost to import prices at the retail level,
but the main impact has yet to flow through.

Graph 29

In headline terms, consumer prices rose by 0.6 per cent in the June quarter to be
0.7 per cent higher than a year earlier. The increase over the past year
has continued to be held down by declines in mortgage interest charges,
the last of which occurred in the September quarter 1997. With housing
interest rates having been broadly stable since then, the quarterly increases
for the CPI and the underlying measure have subsequently moved closer together.
From the September quarter 1998, the Australian Statistician will introduce
the 13th Series CPI, which makes a number of changes to the scope and coverage
of the index. From a practical point of view, the most important change
is the adoption of an ‘acquisitions’ approach to the measurement
of housing costs, which will have the effect of removing mortgage interest
rates from the index.

The rate of increase in private-sector service prices is currently running at just
over 3 per cent, while prices of domestically produced goods increased
by around one per cent over the past year, having slowed significantly
during the past two years. After two years of almost continuous declines,
import prices at the retail level showed little net movement over the March
and June quarters, although they remain below their level of a year earlier.

The exchange rate and import prices

The decline in the exchange rate over the past year has had an important impact on
import prices at the wholesale level that will eventually flow through
to retail prices. At the docks, import prices have increased by around
10 per cent over the four quarters to June. To date, this has had little
effect on retail prices. There was a noticeable increase in the imported-goods
component of the CPI in the March quarter, but in the June quarter this
movement was reversed. Much of this rise and subsequent decline was accounted
for by the prices of imported motor vehicles. No growth was recorded in
the prices of other predominantly imported goods in the June quarter. These
developments illustrate that the pass-through of wholesale price changes
to final retail prices is usually slow, and can vary depending on conditions
in domestic product markets.

The relationship between the exchange rate and developments in the wholesale prices
of imported goods is being complicated at present by the widely divergent
movements in trading-partner exchange rates. The import-weighted exchange rate has depreciated
over the past year by around 7 per cent which, on the basis of past behaviour,
would usually contribute to a somewhat smaller change in imported goods
prices over the same period. The actual increase has been noticeably larger.
As Graph 30 illustrates, the rise in the over-the-docks price of imports
in the past year has been more consistent with, although smaller than,
the decline of the Australian dollar against
the major currencies in the industrialised world (of which the exchange
rate against the SDR is a convenient measure).

Graph 30

This relationship suggests that the major industrialised countries are having a greater
role in influencing the prices of Australia's imports than their share
of Australia's trade would imply. Nonetheless, the exchange rate movement
against the major currencies must overstate the net impact of the recent
currency movements because it does not take account of Asian producers'
ability to reduce their prices. Although data on export prices for the
Asian countries are fairly scarce, evidence from South Korea shows their
export prices have fallen significantly in world currency terms, stimulating
strong growth in their export volumes.

Producer prices

Softness in world commodity markets, as discussed in the section on Balance of Payments
earlier, has also affected Australian producer prices. While the over-the-docks
prices of imported final goods increased by more than 10 per cent over the past year, prices of
imported inputs into manufacturing rose by 6 per cent and the prices of
domestically sourced raw materials fell (Table 6). In both cases,
this primarily reflected recent falls in energy prices.

Table 6: Selected Price Measures

Percentage change

June quarter 1998

Year to June 1998

Input prices

Domestic

– Raw materials

0.1

−1.3

– Intermediate(a)

0.2

1.5

Imported

1.9

6.0

Final manufacturing prices(a)

Domestic

0.2

1.5

Imported

1.3

10.6

Construction prices

House-building materials

0.3

1.7

Other building materials

0.4

0.5

Import prices

Import price index(a)

1.5

10.6

Imported goods component of CPI(a)

−0.5

−1.6

(a) Excludes petroleum.

Developments in input costs and selling prices presented in the business surveys
have broadly lined up with these official data. Input costs are widely
reported to have increased following the depreciation of the exchange rate.
The NAB survey (which covers the entire non-farm economy) points to a modest
increase in prices over the past year. Manufacturing sector surveys, such
as the ACCI-Westpac, Colonial State Bank and Australian Chamber of Manufacturers'
surveys, suggest there were sharp increases in input costs in the first
half of this year, and point to further pressures in the September quarter.
On selling prices, the picture is more mixed; surveys of retailers and
manufacturers suggest growth in final goods prices has remained subdued,
while some price pressure is evident at the wholesale level.

Labour costs

Ordinary-time earnings of adults working full time (AWOTE) increased by 0.4 per cent
in the three months to May, and by 4.1 per cent over the past year (Graph 31).
The increase in this measure of wages continues to display considerable
short-run volatility. Nonetheless, there are some signs that its rate of
growth has slowed. In the first half of 1998, AWOTE increased at
an annual rate of 3.6 per cent, compared with annual increases of around 4 per cent prevailing over much of the preceding
two-year period.

Graph 31

Some confirmation that aggregate wage growth is running at around the 3½ per
cent mark is provided by the newly produced wage cost index. The first
two available observations for the change in wage costs, covering the December
and March quarters, show increases of 0.8 and 0.9 per cent, broadly consistent
with what appears to be the trend rate of growth in economy-wide AWOTE
(Table 7). However, despite the conceptual superiority of the wage
cost index (it is, in principle, unaffected by compositional change and
changes to the working week), longer experience with the index will be
needed to assess its reliability.

Table 7: Indicators of Wage Rates

Percentage change

December
1997

March
1998

June
1998

Latest
six months
annualised

Wage Cost Index

Private

0.8

0.9

–

3.4

Public

0.7

1.0

–

3.4

Total

0.8

0.9

–

3.4

AWOTE

Private

0.5

1.3

–

3.7

Public

0.3

1.9

–

4.4

Total

0.4

1.4

0.4

3.6

The increases awarded under new enterprise bargains have declined over the past year.
From a peak of over 5 per cent in private-sector increases, reached
in mid 1996, the rate of increase specified in new agreements has declined
to 4 per cent in the March quarter 1998, and is likely to have been around
the same in the June quarter. A similar trend can be seen from comparisons
of new agreements with the expiring agreements they replace (Graph 32).
Over the past year, replacement agreements in major enterprises have, on
average, specified lower wage rises than the corresponding agreements previously
operating. The average difference over the year has been around 1½
percentage points.

Graph 32

Inflation expectations

After declining to low levels in 1997, consumers' inflation expectations, as
surveyed by the Melbourne Institute, increased slightly in the first half
of this year, most probably in anticipation of the impact of the lower
Australian dollar on prices. In June, when there was a sharp fall in the
value of the currency, median inflation expectations rose sharply, from
3.4 per cent to 4.5 per cent, their highest rate in two years. Significantly,
almost half of the survey's respondents reported hearing news about
the exchange rate during the previous month. The latest survey reading,
conducted in July when markets were calmer, showed that inflation expectations
had dropped back to 3.4 per cent, close to their level throughout the early
months of the year (Graph 33).

Graph 33

Survey evidence of businesses' inflation expectations provides mixed results
on the near-term outlook. The latest ACCI-Westpac survey contained a sharp
increase in the net balance of respondents expecting to raise prices in
the September quarter, and the ACM survey also shows an expected pick-up
in selling prices from a couple of quarters ago. Both of these are manufacturing-based surveys and are likely to reflect recent increases
in the costs of imported inputs. The broader NAB survey found an average
expected price increase of 0.4 per cent in the September quarter, which
is little changed from recent quarters. At a longer-term horizon, firms'
inflation expectations have eased slightly. The number of respondents to
the NAB survey anticipating inflation to be greater than 3 per cent over
the next ten years declined in the latest survey, although it remains the
case that an expected inflation rate in the 3 to 4 per cent range is the
most common survey response.

A survey of trade union officials, conducted by ACIRRT (Australian Centre for Industrial
Relations Research and Training) following release of the June quarter
CPI, gave a median inflation forecast of 2 per cent over the year to June
1999, rising to 3 per cent over the year to June 2000 (Table 8). The
Bank's survey of financial market economists, also taken just after
the June quarter CPI release, obtained a median forecast of underlying
inflation over the year to June 1999 of 2.5 per cent, down from a forecast
of 2.9 per cent obtained in the corresponding survey a year earlier. Respondents
to this survey expect inflation to decline over the following year, to
a median of 2.4 per cent.

Inflation outlook

The major short-term influence on the inflation outlook continues to be the substantial
decline in the Australian dollar over the past year. The currency depreciation will give a significant boost to import
prices, lifting the overall inflation rate further above the trough reached
in the December quarter 1997. Recent developments, including a further
net decline in the exchange rate over the past few months, appear to have
marginally increased the prospective inflation rate in the near term. However,
this impact comes at a time when other sources of inflationary pressure
are well contained.

By early August, the Australian dollar had depreciated by an average of around 15
per cent against the major currencies, from the levels prevailing in mid
1997, but there are several reasons to expect that the effect on domestic
inflation might be smaller than would normally be expected from a movement
of this size. At the wholesale level, import price increases are being
limited by an increasingly tough international competitive environment,
particularly where east Asian producers have been able to reduce their
export prices in international currency terms. Domestic sources of inflationary pressure are likely to remain subdued. Labour
markets are showing increasing evidence of an easing in wage pressures,
and recent declines in business confidence may prompt a tougher stance
by businesses in wage negotiations.

The net effect of higher import prices and continued subdued domestic inflationary
pressures is likely to be a moderate rise in inflation during the period
in which import prices are adjusting. The inflation rate is projected to
peak at around 2½ to 3 per cent in the second half of 1999, after
which, on current indications, it would decline to around the bottom of
the target range. A source of risk for the inflation outlook in the short
term might arise if there were a significant further weakening in the international
environment, putting downward pressure on the currency. However, these
effects would be partially offset by the accompanying dampening influence
on demand and activity, which could reduce domestically sourced inflationary
pressures.

Footnote

The interest spread is defined as the difference between the average interest rate
received on interest-earning assets less the average interest rate paid
on all deposits. A more complete discussion of Banks' Interest Spreads
is contained in Box E of the Semi-Annual Statement on Monetary Policy, November 1997. [1]